Tax-advantaged Savings for Education requires some planning!

Introduction

• When saving for a child’s college education, many consider using a qualified tuition program (QTP), such as a 529 plan, but a Roth IRA may be an alternative strategy.
• Both QTPs and Roth IRAs offer tax-advantaged savings: contributions are made with after-tax dollars, earnings grow tax-free, and qualifying distributions are not taxed.
• Nonqualifying distributions from both accounts are subject to income tax and a 10% penalty, with certain exceptions.
• Key differences between QTPs and Roth IRAs can make one option more appealing depending on individual circumstances.

Contributions

Who Can Contribute?

• Anyone can contribute to a QTP, including parents, grandparents, or the beneficiary, while only the account owner can contribute to a Roth IRA.

Annual Contribution Limit

• Roth IRA contributions are limited to $7,000 for 2025 ($8,000 if over age 50) or earned income, with phase-out if income exceeds certain thresholds, making high-income taxpayers potentially ineligible.
• QTP contributions are not subject to an income limitation, making them attractive to high-income earners.

Overall Contribution Limit

• There is no annual limit on QTP contributions, but total contributions cannot exceed the beneficiary’s estimated higher education costs.
• There is no limit to how much can be accumulated in a Roth IRA, but lower annual contribution limits can slow growth compared to a QTP.

Tax-free Distributions

• QTP distributions are tax-free if used for the beneficiary’s qualified higher education expenses in the same tax year.
• Roth IRA qualified distributions are available after age 59½, provided the account has been open for at least five years.
• Prior contributions to a Roth IRA can be withdrawn for any reason without tax or penalty before age 59½, but earnings are subject to tax if used for education expenses.

Unused Funds

• A Roth IRA offers flexibility, allowing full access to funds after age 59½, which is appealing for those unsure if their child will attend college.
• Unused QTP funds have limited options to avoid taxes and penalties, but up to $35,000 can be rolled over to a Roth IRA in the beneficiary’s name starting in 2024.

Impact on Financial Aid

• A Roth IRA balance doesn’t count as an asset for the Free Application for Federal Student Aid (FAFSA), while a QTP’s value is included as a parental asset.
• Roth IRA distributions are included in financial aid income calculations, potentially affecting future aid, whereas QTP distributions are not if reported as an asset.

Other Considerations

State Tax Benefits

• Many states offer a tax deduction or credit for QTP contributions, often favoring their state’s plan, while there are generally no comparable state tax benefits for Roth IRA contributions.

Investment Choices

• QTPs typically have limited investment options, while Roth IRAs allow investment in a wide range of assets, enabling more aggressive growth strategies.

Interaction with Education Credits

• Tax-free QTP distributions must be reduced by any qualifying expenses used to claim education credits, but there is no similar rule for Roth IRAs.

Savers Credit

• Taxpayers below a certain threshold may be eligible for a nonrefundable credit for Roth IRA contributions, but this credit is unavailable to children under 18, full-time students, or dependents.

Summary

• QTPs and Roth IRAs offer tax-advantaged ways to save for higher education, with QTPs being attractive for high-income earners due to higher contribution limits and no income restrictions.
• Roth IRAs provide flexibility for retirement savings if funds are not needed for education.
• The best choice depends on factors like income, availability of other resources, and investment preferences, and a coordinated strategy using both may maximize benefits.

 

RJC  June 19, 2025